Reduce the behaviour gap with a higher exposure to diversified funds

Avoid trying to time entry and exit from funds; hold for at least one complete cycle

A recent report by Morningstar says that the returns Indian investors earn are much lower than what the mutual funds (MFs) they have invested in earn. This trend is visible across asset classes and types of funds.

Across the MF universe, the gap was 2.7 percentage points (ppt) over the three-year period, 2.5 ppt over the five-year period, and 5.8 ppt over the 10-year period (data as on June 30).

Poorly timed entry and exit 

The primary reason for this gap (referred to as behaviour gap) is investors’ poorly timed entry and exit from funds.  

“Investors have a persistency bias. They believe an asset class or a fund that has given high returns in the past will continue to do so in future. They ignore the cyclicality in returns,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.

Often, when investors enter a fund based on recent performance, its best days are already behind it. The fund then witnesses flat or negative returns. Those who entered close to the peak enjoy much poorer returns than the fund.  

“When a fund’s performance has been poor for a considerable period, investors believe investing in it was an error. They then compound their initial error of entering near the peak by exiting near the bottom of the cycle,” says Arvind A Rao, certified financial planner and founder, Arvind Rao & Associates.  

Lower gap in diversified funds

The behaviour gap tends to be lower in a well-diversified category, such as large-cap funds.

Investors tend to invest regularly in these funds, as they are not the flavour-of-the-season kind of funds. They also stay invested in them for longer. All these factors reduce the behaviour gap.

Higher gap in sector/thematic funds

The average three-year return from technology funds was 27.5 per cent, but investors in these funds earned less than 3 per cent on average. While technology funds ran up sharply in 2020 and the first half of 2021, the bulk of the inflows came into them only in the second half of 2021.

Returns from sector/thematic funds are lumpier.

“The behaviour gap tends to be higher in categories that are more prone to excitement,” says Avinash Luthria, founder, Fiduciaries.

In sector/thematic funds, investors have a greater need to switch. This raises their timing (of entry and exit) risk and transaction costs.

“While investors are happy with the highs, they are unable to ride out the lows,” says Rao.

Debt funds

In debt funds, the gap tends to be higher in dynamic bond funds and gilt funds, and lower in less volatile categories, such as shorter-duration funds.

“Both dynamic bond funds and gilt funds have a duration element and tend to be more volatile,” says Belapurkar.

What should investors do?

The core portfolio, which should constitute the bulk, should be built using diversified funds. Investors should put money in them steadily using systematic investment plans.

“Have a limited number of funds in each category,” says Rao.

Investors may have a small allocation to sector/thematic funds in their satellite portfolios. Those who can take directional calls based on fundamental research may bet on them. Those who cannot should avoid these funds. If at all they invest, they should choose sectors or themes that are out of favour.

Allocation to individual sector/thematic funds shouldn’t exceed 5 per cent of the equity portfolio (exposure to all such funds shouldn’t exceed 15 per cent). Each equity fund should be held for one complete cycle — at least seven years.

“A buy-and-hold approach that lowers transaction cost can reduce the behaviour gap,” says Luthria.

The bulk of an investor’s holdings in debt funds should be in shorter-duration funds.
 

Besides diversifying across asset classes (equity, debt, commodities), investors should also diversify across sub-asset classes (large-cap, mid-cap, and small-cap) and fund styles (growth and value).

SIPs/STPs reduce timing risk

• If the markets have gone up over a period of time, a lump sum investment done at the start of this period is likely to outperform SIP returns over the same period
• But most investors don’t have a lump sum; SIPs enable them to invest, according to their cash flows
• By putting investments on autopilot, SIPs remove investors’ tendency to try and time the market
• Investors with a lump sum to invest should take the systematic transfer plan route to avoid taking a call on the level of the market